TOPIC 4

(CHAPTER 4)

VALUATION OF SHARES

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LEARNING OUTCOME:
At the end of this lecture, students should be able to:
✓ Explain the:
1. The need to do business valuations
2. Assets-based valuation models
3. Income-based valuation models
4. Cash-flow valuation models

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CONTENTS:

2- Assets-
1- Business
based
valuations
valuation

3- Income- 4- Dividend
based valuation
valuation model

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 1- BUSINESS VALUATIONS

1.2- Why
1.1- Valuations 1.3- Stock
Definition of Shares Valuation
of valuation are Methods
Needed?

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1.1- Definition of Valuation
• Process of estimating the true value of an asset which is known as INTRINSIC
VALUE
• expected worth of the stock on paper
• maximum price investor are willing to pay
• minimum price investor are willing to sell

• To predict future price – potential market price

• Undervalued
• Overvalued

• To help in decision making.

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1.2- Why Valuations of Shares are Needed?

1. To fix an issue price for an unquoted company to be listed.

2. Takeover bid and the offer price for the purpose of merger and acquisition
activities.
3. For the purposes of taxation and as collateral for a loan made by a company.
4. When a group holding company is negotiating the sale of its subsidiary to a
management buyout team or to an external buyer.
5. When a shareholder wishes to dispose of his holding especially if a large or
controlling interest is being sold..
6. When a company is being broken up in a liquidation situation or the company
needs to obtain additional finance or refinance current debt.

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1.3- Stock Valuation Methods

The income-
The asset-based The dividend
based valuation
valuation method valuation method
method

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 2- ASSETS-BASED VALUATION

• Determines a company’s ordinary share value by analyzing the value of the

company’s assets.
• The difficulty in an asset valuation method is establishing the asset values to
use.
• Asset valuation can be based on; Historic cost basis/book value, replacement
basis, or realizable basis/break-up value.
• Weaknesses
1. Assumes that investors normally buy a company for its balance sheet assets.
2. Ignores non-balance sheet intangible assets which may include a strong and
experienced management team and highly skilled workers.

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 2- ASSETS-BASED VALUATION (Cont’d)

• Method is useful
1. As a measure of the “security” in the share value for comparison with
other valuation approaches.
2. As a measure of comparison in a scheme of merger – asset backing
valuation.
3. As a “floor value” for a business that is up for sale or to set a minimum
price in a takeover bid.

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 2- ASSETS-BASED VALUATION (Cont’d)

• How to calculate?
1. The value of an ordinary share:
Net tangible assets
Number of ordinary shares outstanding

2. Intangible assets (including goodwill) should be excluded, unless they

have a market value (for example, patents and copyrights, which could be
sold).

• Example- page 128-129 (NRV)

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 3- INCOME-BASED VALUATION

• One of the most common methods for valuing share price.

• Apply the price-to-earnings ratio (P/E)
Market price per share
• P/E ratio =
Earnings per share

• By selecting a suitable P/E ratio and multiplying this by the EPS, the market
price per share or the total value of a company can be computed.
• The Intrinsic value of a stock (Market price per share) = EPS x P/E ratio.
• Value of a company (market capitalization) = Total earning x P/E ratio

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 3- INCOME-BASED VALUATION (Cont’d)

EXAMPLE 1

The latest financial statements of food retail company Kesang Berhad, show
earnings per share of RM0.20 and the average P/E for the companies in the same
industry is quoted at a ratio of 15 at the time of valuation.

A possible value could be computed as follows:

• The market price per ordinary share is RM3 (RM0.20 x 15).

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 3- INCOME-BASED VALUATION (Cont’d)

EXAMPLE 2

Seri Indah Bhd’s expected earnings after taxes (EAT) is RM300 million. The current
market price of its common stock is RM5.00 per share. At present the company has 500
million shares outstanding and a PE ratio of 10.
i- Calculate the intrinsic value of Seri Indah Bhd’s common stock.
IV = P/E x EPS
𝑹𝑴𝟑𝟎𝟎 𝒎𝒊𝒍𝒍𝒊𝒐𝒏
= 10 x = RM6.00
𝟓𝟎𝟎 𝒎𝒊𝒍𝒍𝒊𝒐𝒏

ii. Would you buy the share at its current price? Why?
Yes, because the market price of the common stock is undervalued. IV > market
price.

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 3- DIVIDEND VALUATION MODEL

• Based on the theory, the equilibrium price for any security depends on the future
expected stream of income from the security discounted using an appropriate cost of
capital or a required rate of return.
• John Williams (1938) stated that the price of a stock should reflect the present value
of the share’s future dividends.
• In equation form, this is the statement of the DVM: Dividend
∞ paid in time t
𝑫𝒕
𝑷𝒓𝒊𝒄𝒆 = ෍ 𝒕
𝟏 + 𝒌𝒆
𝒕=𝟏

The required rate of

return by investor
PV of future
at the time of
cash flow
valuation t

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 3- DIVIDEND VALUATION MODEL (Cont’d)

• The general model can be formulated if the company’s dividends are expected to
follow these basic patterns:

3.1- Zero 3.2- Constant 3.3- Differential

Growth growth growth

(D0 = D1 = D2 ..... D∞) (Dt = Dt-1 (1 + g))

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3.1- Zero Growth

• Assumption:
1. Same amount of dividend is paid every year (zero growth)
2. The required rate of return for the share remain constant at ke which is
equal to the cost of equity for that company.

PV of future
cash flow
D D D
Price (P0 ) = + + ..... =
(1 + k e ) (1 + ke ) 2
ke
where
D = Constant annual dividend
ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable

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3.1- Zero Growth (Cont’d)

EXAMPLE
Mara Berhad is expected to pay a dividend of RM1.10 per share every year in the
foreseeable future. Investors require a return of 15% on investment in the
company’s shares. Applying the DVM, what is a fair price for the company’s
share?
∞
𝐷𝑡 𝐷 𝑅𝑀1.10
Price = ෍ = = = 𝑅𝑀7
(1 + 𝑘𝑒 )𝑡 𝑘𝑒 15%
𝑡=1

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3.2- Constant Growth

• Assumption:
1. Company pay dividend that has current value of D0.
2. Dividend grows at a constant rate.

𝐷0 (1 + 𝑔) 𝐷0 (1 + 𝑔)2 𝐷0 (1 + 𝑔) 𝐷1
Price (P0 ) = + 2
+. . . . . = =
(1 + 𝑘𝑒 ) (1 + 𝑘𝑒 ) (𝑘𝑒 − 𝑔) 𝑘𝑒 − 𝑔

PV of future
Where; cash flow
D0 = Current year’s dividend
g = Growth rate in earnings and dividends
D0 (1+g) = Expected dividend in one year’s time (D1)
Ke = Shareholders’ required rate of return
P0 = Market value excluding any dividend currently payable

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3.2- Constant Growth (Cont’d)

EXAMPLE
Suria Berhad is expected to pay a dividend of RM0.90 per share in one year. In every
subsequent year, the dividend is expected to grow by 4% annually. Investors require a
return of 10% on the firm’s stock. Applying the DVM, what is a fair price for the
company’s shares? If the current market price is RM17, should you buy Suria’s share?

∞
𝐷0 (1 + 𝑔)𝑡 𝐷1 𝑅𝑀0.90
Price = ෍ 𝑡
= = = 𝑅𝑀15
(1 + 𝑘𝑒 ) 𝑘𝑒 − 𝑔 10% − 4%
𝑡=1

As the intrinsic value is below the current price of RM17, the stock is overvalued. Thus,
one should not buy this stock.

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3.2- Constant Growth (Cont’d)
EXPECTED GROWTH RATE OF DIVIDEND (g)
• Current Dividend (D0) = Dividend in year T-t * (1+ growth rate)T-t
D0 = D T-t x (1+g)T-t
EXAMPLE
A company is just about to pay a dividend of RM0.50 a share this year. Four years ago, its
dividend was RM0.25 a share. What was the average annual growth rate of dividends over
the four years?
Dividend 4 years ago x (1 + g) 4 = Current Dividend
(1 + g) 4 = Dividend this year / Div.four years ago
= RM 0.50/RM 0.25 = 2
(1 + g) =2¼
= 1.189
Therefore g = 1.189 – 1 = 0.189 = 18.9%.

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3.2- Constant Growth (Cont’d)
EXAMPLE
𝐷0 (1 + 𝑔)
Price (P0 ) =
• No. of shares : 10 million (𝑘𝑒 − 𝑔)
• Current Stock Price: RM5.85 Answer:
• EPS: RM0.60 D0 = 70% * RM0.60 = RM0.42
• Proposed payout: 70% Div 2 years ago x (1 + g )2 = Proposed div.
• Div. per share 1 year ago: RM0.41
0.40 (1+g)2 = 0.42
• Div. per share 2 years ago: RM0.40
1+g = (0.42/0.4)1/2 = 1.051/2
• Beta: 1.5
g = 1.0247 – 1 = 2.47%
• PE: 11
• Risk Free rate: 4%
• Market Return: 8% R = Rf + beta (Rm - Rf) = 4 + 1.5 (8-4) = 10%

Calculate intrinsic value of the stock. IV = 0.42 (0.1+0.0247)/(0.1-0.0247) = RM5.72

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3.2- Constant Growth (Cont’d)
EXPECTED GROWTH RATE OF DIVIDEND (g)- Earning retention model

g = ROE/ROI/ROCE x RR

where,
RR = Retention ratio (1 – Dividend payout ratio)

EXAMPLE (page 111-112) Answer:

Dividend per share = EPS x DPR = RM5 x
• ROE: 15% 0.4 = RM2
• Expected EPS in coming year: RM5.00 Retention ratio = 1 – 0.4 = 0.6 or 60%
• Required rate of return: 14%
• Dividend payout ratio: 40% g = ROE x RR = 15% x 0.6 = 0.09 or 9%

Calculate intrinsic value of the stock.

IV = 2 / (0.14 - 0.09) = RM40

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3.3- Differential Growth Model

• Two stages growth period;

1. Variable growth
2. Constant till perpetuity or grow at constant rate till perpetuity

• The intrinsic value of the ordinary share can be computed as follows:

P1 + P2
PV period 1 (variation) + PV period 2 (constant)

PV of future
cash flow

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3.3- Differential Growth Model (Cont’d)
EXAMPLE (page 114)
Macy Berhad paid RM1.50 dividend per ordinary share last year. The company's
policy is to allow its dividend to grow at 5% for the first four years and then the
rate of growth changes to 3% per year from year 5 and so on. What is the value of
the ordinary share if the required rate of return is 8%?
P1 = PV up to year 4. (Variation)
t Dividend (Dt) PVIF 8%, t PV
1 RM1.5750 0.9259 RM1.4583
D0 (1+g) [1.5 x 1.05]
2 RM1.6538 0.8573 RM1.4178
D1(1+g) [1.5750 x 1.05]
3 RM1.7365 0.7938 RM1.3784
D2(1+g) [1.6538 x 1.05]
4 RM1.8233 0.7350 RM1.3401
D3(1+g) [1.7365 x 1.05]

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PV PERIOD 1 (P1) = RM5.5946
3.3- Differential Growth Model (Cont’d)
EXAMPLE (Cont’d)
P2 = PV from beginning of year 5 or end of yr 4 to perpetuity. (Grow at constant rate)

Expected Div. in year 5, D5 = 1.8233 (1 + 0.03) = RM1.8780

PV PERIOD 2 (P2) = 1.8780/(0.08-0.03) x 0.7350

Price beginning of year 5 or

end of year 4
(Expected Price in year 5)

= RM37.56 x 0.7350
= RM27.6066
Intrinsic Value of share = P1 + P2
= RM5.5946 + RM27.6066
= RM33.20

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REFERENCE:
Mohd Nizal Haniff, Norli Ali, Norashikin Ismail, Noreena Md Yusoff. Introduction to
Malaysian Financial Markets (2021). Mc Graw Hill.

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